Rickards: Bitcoin meets the taxman

Bitcoin is much in the news. Whether it’s the supposed unveiling of the mysterious creator of bitcoin, the tragic death of a prominent bitcoin executive, or the bankruptcy of the best-known bitcoin bank, the topic of bitcoin is hard to avoid. But, this raises the question — what is bitcoin?

Bitcoin is a digital currency backed by nothing. If that sounds strange, it shouldn’t. The dollar is also a digital currency backed by nothing. It’s true we have a few paper dollars in our purse or wallet, but these are mere tokens of dollarness. The overwhelming majority of dollar transactions, from credit cards to the government bond market are digital. Dollars emerge from and vanish into thin air — just like bitcoins.

Dollars come from computers at the Federal Reserve. Bitcoins come from computers all over the world not controlled by any central bank or government. This is also not as strange as it seems. In 1999, a decade before bitcoin was invented, Milton Friedman said, “The internet is going to one of the major forces reducing the role of government. The one thing that’s missing, but will soon be developed, is a reliable e-cash, a method whereby … you can transfer funds from A to B without A knowing B.” That is exactly what bitcoin is.

Bitcoin skeptics are quick to point to the recent failure of bitcoin bank, Mt. Gox, as evidence that the phenomena will be short-lived. But regulated brokers doing business in dollars fail all the time. Look no further than Lehman Brothers, whose failure marked the death of that firm, but not the dollar’s demise. Currencies exist independent of the entities that use them. The Mt. Gox failure is a speed bump, not the end of the road.

Skeptics also point to the use of bitcoin for criminal transactions and the arrests of prominent bitcoin promoters as cause for concern. But dollars have been used for crime from Al Capone to Bernie Madoff. Again, the critics are confusing the currency with the uses to which it is put.

If bitcoin has so much in common with the dollar, does this mean that bitcoin may soon rival the dollar as a store of value? This is unlikely because the dollar has set a trap for bitcoin in the form of taxes. If you acquire a bitcoin for $100 and use it later to purchase $200 of goods, the IRS says you have a $100 gain on the sale of bitcoin that must be reported on your tax return. It’s no different than buying and selling a share of stock. It seems likely that many of the technophiles so ardent about Bitcoin are not bothering to report those gains. They may be hearing from the IRS soon.

And don’t even think about trying to pay your taxes with bitcoin. The dollar has a monopoly as legal tender for the payment of U.S. taxes. According to John Maynard Keynes and many other economists, it is the ability of state power to coerce tax payments in a specified currency that gives a currency its intrinsic value. This theory of money boils down to saying we value dollars only because we must use them to pay our taxes — otherwise we go to jail.

Bitcoin is extremely volatile. In recent years, the value of bitcoin has fluctuated widely from $1 to $1,000. It’s true that dollars fluctuate in value relative to other currencies such as the euro. But those changes are typically measured in fractions of pennies, not jumps of $100 per day.

Bitcoin does not have a lengthy track record in bull and bear markets. Everyday Americans have no reason to own bitcoins for now. They’re too volatile and there are too many unanswered questions about liquidity and how bitcoin will perform in a financial panic such as 2008.

One solution to the bitcoin volatility problem is to link bitcoin to gold at a fixed rate. This would require consensus in the bitcoin community and a sponsor willing to make a market in physical gold at the agreed value in bitcoin. This kind of gold-backed bitcoin might even give the dollar a run for its money as a reserve currency, especially if it were supported by gold powers such as Russia and China who are looking for ways out of the current system of dollar hegemony.

Bitcoin is not just a currency, it is also an open-source technology that can facilitate cheap, secure, distributed processing for all kinds of property transfers including stocks, bonds and land titles. It is this technology potential that has attracted interest from investors such as Marc Andreessen and the Winklevoss twins. Bitcoin technology may survive even if the bitcoin currency dies out, much as human DNA survived even as Neanderthals went extinct.

Bitcoin’s future may lie in its role as a technology platform for inexpensive verifiable transfers rather than its role as a currency. To the extent it remains a currency, bitcoin is an interesting, if risky, experiment. Just don’t try paying your taxes with it.

James Rickards is the author of “The Death of Money” from Portfolio/Penguin and a portfolio manager for the West Shore Group